Political excitement and uncertainty has blighted the Brazilian economy in the past few months. The prospect of the left-wing candidate, Luiz Inacio Lula da Silva, winning the elections and eventually running Latin America's biggest economy, has terrified the financial markets.
On October 6 Lula, as he is popularly known, came within a whisker of an outright victory in the first round of voting for a new Brazilian President. He obtained just under 47% of the vote, but he needed more than 50% for an outright victory.
The second round of the election is due next Sunday and Lula, a former metalworker and trade unionist, now looks assured of victory as he has gained further support from the third and fourth candidates.
The outgoing government of President Fernando Henrique Cardoso has increased the transparency of Brazil's policy environment and had a consistent macro-economic framework over the last four years, which includes the floating exchange rate, contained inflation and fiscal consolidation strategies.
With the prospects of Lula's victory, international investors are concerned about whether he will prioritise social spending and alter the course of economic policy. Should there be a slippage in the tight fiscal policy this might adversely hit bondholders, therefore investors are eager to see a consistent economic policy as was experienced in the past four years.
This uncertainty linked to the presidential elections has caused Brazil's bonds and currency to drop by more than a third since April. The credit spreads shot above 22% over the US Treasuries. This means that the risk premium has increased on such bonds and therefore the government has to pay higher interest rates to refinance existing debt. Brazil's benchmark 8% bond due in 2014 has dropped to around $0.49 from $0.82.
It is evident that with this sort of interest rate investors are unsure whether they will get their money back on maturity of the notes. In actual fact the government had to finance about half the debt that matured last month from its cash, due to lack of investors' willingness to buy government debt.
Apart from high interest rates the government of Brazil faces other problems, such as currency. With a major part of the $260 billion debt linked to the dollar and with the real, the Brazilian currency, falling around 40% this year, the Brazilian government is in an adverse position to service such debt.
Brazil's outlook remains gloomy with the currency hitting record lows, international reserves dropping about $6.1 billion since June even after the International Monetary Fund in September issued a loan payment to Brazil. Recently the Central Bank increased interest rates to control inflation which might hinder the much needed economic growth to sustain the debt burden.
Credit rating agencies Moody's, Fitch's, and Standard & Poor's which assess the ability of borrowers to repay their debt downgraded Brazil's credit ratings. The S&P's ratings of Brazil foreign currency ratings has been lowered to B+/Negative/B from BB-/Negative/B and the local currency lowered to BB/Negative/B from BB+/Negative/B.
We await next Sunday's results to assess the scenario further.
Mark Azzopardi, MA (Finance), B.Com. is investment and finance director of Jesmond Mizzi Financial Services Ltd, e-mail: mazzopardi@jmfs.net